Monday, February 1, 2016

The importance of multiple income streams

It is nice to have a diversified income stream. While many seem to look for a focused method, I look for a diversified method of generating income. The more diversified, the better.

One of my primary income streams today is my employee salary. This is the main and only income stream for majority of people in the US. The problem is, I generate it from one employer, so if they don’t like me, this stream will end. So I am at the mercy of the employer at some level. The goal is to diversify away from relying 100% on this stream.

The second income stream is the dividends from my income portfolio. I am not dependent on any one company for this income stream. In fact, I believe that if one holds at least 30 – 40 dividend paying companies, they should not be worried if one or two of them simply stopped paying dividends. Of course, the portfolio would likely be built slowly and over time, and should be representative of as many sectors as possible. If you have half of your portfolio in a single sector such as energy, or financials or consumer staples, you are way too concentrated however. You want to avoid risks that will take down a whole sector during a crisis, or a change. An example was the dividend cuts to banks during the financial crisis. Many expect a lot of dividend cuts in the energy sector today. Whether those fears are overblown, or not, remains to be seen.

Most of my dividend income (89% - 90% of it) will come from approximately 50 stock positions. I therefore feel secure in this income stream, because I am not overly reliant on any single stock. Even if I were to sell a stock because it cut dividends, I could replace a large portion of that income by purchasing another income generating security. This is what I recently did by selling Kinder Morgan (KMI) and purchasing Enterprise Products Partners (EPD) and Diageo (DEO).

The reason why I really want to be diversified is in order to protect myself from factors in the future that I fail to see materializing and getting out in time. The truth is, I purchase a company after I do an extensive amount of work. However the worlds is largely unpredictable, as consumer tastes change, business environments change, competitive factors change and also investors make mistakes as well. It is difficult to forecast certain factors in advance. For example, investors in Kellogg (K) were doing pretty well after 44 years of increased dividends through the early 2000s. However, after changes in environment, the company froze dividends. Investors in Winn-Dixie did well with over 58 years of dividend increases, after which the company stopped raising and then cut it, only to go bankrupt a few years later.

The thing to remember is that things change. Just because McDonald’s (MCD) has dominated the fast-food restaurant industry for 40 - 45 years, doesn’t mean that the next 40 years will be as good. The thing that does it in, might not be known until 2030. Or it could be something that you see today, but choose to ignore. That’s why one needs to expect the best, but still prepare for the worst just in case. Just like the case with my personal income however, it is important that corporations you are investing in have diversified sources of income. A company that is overly dependent on a certain supplier, or a certain geographical market or even a certain product is overexposed to the risk of something going wrong. For example, several consumer staples companies have operations in Venezuela, which have been a drag on results. Since those companies operate in almost every country on earth, these losses in Venezuela are just a drop in the bucket that doesn't affect results. A pharmaceuticals company that derives most of its revenues from a certain drug could be in a lot of trouble once the patent for this drug expires, and it is open to competitors.

I also want to avoid situations where a company has showered me with rising dividends for 20 – 30 years, and I stop being rational in evaluating the business. This means, if a company I own starts cutting dividends, I will get out of it right away. I bought the company because I believed it will raise dividends over time in the first place; Thus once this criteria is no longer met, it is evidence that something has changed. By selling off my exposure, I will be able to objectively evaluate the situation. If the company manages to grow distributions again, I will get back in, provided the entry price is attractive.

The other thing to remember is that one needs to get rich just once in their lifetime. The goal of a successful retirement is to convert a lifetime worth of savings into an income generating machine, which helps you stay retired. This dividend machine gives you the choice of doing whatever you want, even if you want to keep working. That’s why it is important to be overly conservative, than reckless. I constantly see investors who take huge gambles in a greedy effort for homeruns. It is important to never risk what you have and need for what we don't have and don't need. If one has the financial security to live off dividends, and thus the flexibility to be master of their own time, then gambling their nest egg in order to make them twice or ten time or one hundred times richer is actually not a very smart move.

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